Economics is confusing at the best of times. But, at the moment, it’s downright counter-intuitive.
Inflation is at its highest in decades, and we’re feeling the pain of the lower real wages that brings. Meanwhile, unemployment is its lowest in half a century, with virtually anyone who wants a job able to get one.
Interest rates are climbing sharply. Home prices are sliding, yet rents are taking off. The United Kingdom is on the brink of financial crisis. Talk of a global recession is everywhere.
Even if you don’t much mind what’s happening (you mightn’t be much affected or you might in fact be benefiting in some way), you’re likely finding it hard to come to grips with it all. Certainly, our policymakers are.
It began with the pandemic
The first thing to understand about what’s happening is that it can’t be divorced from the pandemic.
Two years ago, early in the pandemic, Australia went into recession for the first time in 30 years.
And what an unusual recession it was. It was sharp, but rather than following the collapse of a speculative bubble or a downturn in the business cycle, it followed years of perfectly sustainable, if weak, economic performance.
It’s worth recalling a few things. Australia handled the public health side of the pandemic better than most. That meant that, although sharp, the collapse in economic activity was less severe than decision makers anticipated.
Even though generally still employed, Australians were much less able to spend. International travel, dining out, and going out had to be put on hold.
At the same time, Australia put in place one of the largest fiscal and monetary support programs in the world. Interest rates were set to zero and the Reserve Bank used unconventional tools to flood financial markets with money.
JobKeeper and the cash-flow boost for businesses, along with the JobSeeker supplement (and loosened eligibility conditions), cash transfers for government benefit recipients, and A$38 billion in superannuation withdrawals constituted the largest fiscal stimulus in Australian history.
Support that couldn’t be spent
Households and businesses were awash with cash during the pandemic – but with not many places to spend it. Much of that spending was simply delayed.
Without the benefit of hindsight, this shouldn’t be viewed as a mistake. As Australia’s leading monetary economist, Professor Bruce Preston of the University of Melbourne, put it, we took out prudent insurance.
It had been 100 years since the last pandemic of this scale, and it was impossible to tell just how bad things would get. It was safer to do too much than too little.
But just as insurance comes with a premium, so too does too much stimulus. Once the economy reopened, too much money chasing too few goods and services would only end in one way: higher prices.
This has been exacerbated by supply chain constraints, some simply the result of switching the global economy off and on and others resulting from the effect of Russia’s invasion of Ukraine on global commodity prices.
Then the floodgates opened
The trouble with high inflation is that we can’t count on it solving itself. It is true that higher prices cut real wages, choking off spending and helping dampen prices. But it is also true that they can feed higher inflation expectations, which do the opposite.
If people expect high inflation they’re more likely to bring forward purchases simply because they expect prices to rise. And workers demand higher wages, and businesses higher prices, in anticipation of the higher prices they will themselves face in future.
In this way, inflation can become self-reinforcing and thus harder to arrest. That’s why monetary (interest rate) policy and fiscal (government tax and spending) policy have been rapidly tightened across the world – to ensure a temporary episode of high inflation doesn’t become entrenched.
It looks as if this has already occurred in the United States, the United Kingdom, and Europe. It’s not yet clear whether it will happen in
The loose monetary policy across the world through the 1970s provides a lesson for what not to do in a situation like this. It took a decade, well into the 1980s, to get inflation under control.
Ideally, policymakers would have seen inflation pressures building and begun to tighten settings sooner and more gradually. The later the reaction, the sharper it has to be – and the more damaging the economic consequences.
Australia’s Reserve Bank was slow off the mark, months behind the Reserve Bank of New Zealand and a month behind the US Federal Reserve. It’s hard not to see that as complacent.
And Australia’s federal government continued to hold its foot on the gas long after the bank started to hit the brakes – with massive additional stimulus irresponsibly committed to by both sides of politics during the May election.
And we’ve seen no action yet from our new government on inflation. It is hard to tell what it is waiting for – perhaps next week’s budget.
Its messaging isn’t helping. The treasurer’s constant references to a “dangerous” global economy is irresponsible at a time of fragility – he needs to remember he is the treasurer now – his words can have a real effect on outcomes.
And the Reserve Bank’s traditionally poor communication hasn’t gotten any better. It pivoted at this month’s board meeting, halving the rate of increase in interest rates, but failed to clearly explain the reasoning in its accompanying statement.
Recession or not, it’ll be a bad couple of years
The word “recession” is unhelpfully binary. Economists don’t even agree on its definition. In an unusual situation like a pandemic, or post-pandemic, its meaning is even emptier.
One thing we do know is that global economic growth, including growth in Australia, will be far slower over the coming two years than we expected mere months ago.
We overestimated the global economy’s ability to smoothly rebound from the pandemic. And we didn’t anticipate Russia’s invasion of Ukraine.
Australia can be expected to fare better than most countries. It is less exposed to the energy price shocks than Europe and the United Kingdom, and to some degree, being a big energy exporter, benefits from high prices.
But there is a lot of uncertainty about China – Australia’s biggest export customer. A sharp downturn there, precipitated by something like a real estate collapse, would pose a serious risk to the Australian economy.
It’s important to note that the problems we are facing are likely to be temporary.
While nobody has a crystal ball, it seems reasonable to expect a return to something resembling normal, with our old rate of economic growth resuming within a couple of years.
Before you know it, we’ll be consumed once more by debates about how to rekindle what was weak growth, weak wages growth, and weak productivity growth – our economic preoccupations before the pandemic struck.